Thinking Things Over              October 14, 2011

Volume I, Number 13

By John L. Chapman, Ph.D.                                                                                                                         Washington, D.C.

With the possible exception of the National Weather Service in the case of predicting the path of an incoming hurricane, the entirety of the federal government suffers from a heavy institutional bias toward preternatural optimism.  This is true of all parts of any government bureaucracy, which seeks to both mollify the taxpaying citizens who perpetuate its existence, and justify its funding with measures of success in promoting public welfare.  But it is almost pathologically embedded in the case of officialdom at the Federal Reserve and U.S. Treasury, charged with oversight of the nation’s economy and monetary system.  Consider the following, from the stormy year of 2008, in the run-up to the failures of Bear Stearns in March, followed by the meltdown of Fannie Mae, Freddie Mac, AIG, and Lehman Brothers in September:

“Among the largest banks, the capital ratios remain good, and I don’t anticipate any serious problems among the large, internationally active banks that make up a very substantial part of our banking system.”    – Ben Bernanke, February 28, 2008

“The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.”            — Ben Bernanke, June 10, 2008 

“The GSEs [Fannie Mae and and Freddie Mac] are adequately capitalized, and are in no danger of failing.”                                  — Ben Bernanke, July 16, 2008       

 ”[I]t’s a safe banking system, a sound banking system. Our regulators are on top of it. This is a very manageable situation…..  remember, our economy has got very strong long-term fundamentals, solid fundamentals. And you know, your policymakers here, regulators, we’re being very vigilant.”     — Henry Paulson, July 21, 2008

“We have no plans to insert money into either of those two institutions.” (Fannie Mae and Freddie Mac)                                          — Henry Paulson, August 10th, 2008

This is a sobering history to keep in mind whenever these agencies speak: one can almost guarantee some amount of positive overstatement is included.  What then, are we to make of an unusual amount of gloom in their pronouncements?  Let us examine the latest example in detail.

On Wednesday, the Federal Reserve released its meeting minutes from the September 20-21 meeting, as per their policy of delaying this by three weeks.  The art of “Fed watching”, which consists of ravenously devouring these minutes, taking in every Fed speech, and even tracking Chairman Bernanke’s travel and meeting schedules, has almost become a professional science: there are hundreds of finance professionals now engaged in it, many almost full-time.  The reason is simple: it can pay off handsomely to know what the Fed is going to do, before others know it.  And for blocks of time for anything other than the immediate short run, the correlation between changes in the money supply and asset prices is economically, if not statistically, significant — the co-movement is strong.

Given this, plus the fact that Chairman Bernanke took the highly unusual step of expanding this to a two day meeting, and that the downbeat summary assessment at the meeting’s conclusion caused a sharp sell-off in U.S. and then global equities on September 21-22, we read these September minutes cover-to-cover.  The minutes’ summary section that had led to the global sell-off is what piqued our curiosity to read the details this week:

[The Board] ….anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate [of price stability along with maximum growth in output and employment]. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.

For a normally placid and bland group, that phraseology was alarming, and within 15 minutes of its release on September 21, the Dow Jones Industrials were off more than 100 points, finishing much lower later that afternoon.  This phraseology therefore tipped us off that this week’s release might contain clues as to how deep the real level of pessimism is within the Fed, because  the above wording was an unambiguous warning — as Mr. Bernanke no doubt intended.  So, having now read the entire document and, perhaps due to the wisdom borne of experience, we have developed a reasonably clear understanding of what the economy will look like through 2012.  Analysis of these minutes is revealing, because even given the usual obfuscatory “Fed-speak”, there were some blunt warnings that bear our attention.  The caveat to bear in mind when reviewing the following is, of course, the reason for the quotes above: the Federal Reserve, like the U.S. Treasury, can be horribly wrong about things, asserting one (positive-biased) view of the world in 2008 right up until its diametric (negative) opposite occurred.  Today’s question before us is, if the Fed can be said to be negative-biased, can it be wrong the opposite way?  Let us see, based on learnings from the meeting minutes.

The Federal Reserve’s Balance Sheet Is Going to Grow, Perhaps Dramatically

First, the Chairman took the pointed step of reviewing three options for expanding the Fed’s balance sheet, known euphemistically as “printing money” when taken to an extreme; ominously, the third option carried the moniker we have come to know well: large-scale asset purchase program.  In this scenario, the Fed would purchase longer-term Treasury securities, increasing the size of its balance sheet and the supply of reserve balances.  So this is the first key thing to note: a QE3 is definitely on the drawing board.

The Fed kept large-scale purchases on the shelf for now, but it did decide to execute another of the three options, called Operation Twist: this involves the Fed’s purchase of $400 billion in long-term Treasury securities, and selling the same amount of shorter-term Treasuries.  These transactions would significantly increase the average maturity of the Fed’s U.S. government bond portfolio, but the size of the Federal Reserve’s balance sheet and the level of reserve balances would be largely unaffected in the near term.  That is to say, Mr. Bernanke & Co. took pains to point out in their statement that “Operation Twist” was nothing more than a flattening of the yield curve, designed to bring down rates at the long end that, pari passu, would bring down mortgage rates and other commercial loan rates that affect investment.   Thus, the implicit assertion is that with no increase in the supply of money itself, Operation Twist would have no capacity for price increases the way the QE1 & 2 balance sheet expansions theoretically could.

M.I.T.’s Matt Rognlie, one of the economics profession’s new generation of rising stars, points out that this may well not be correct:

QE2 was equivalent to the combination of two open market operations:

• (1) Buying short-term Treasuries with newly created money.
• (2) Swapping short-term Treasuries for longer-maturity ones.

The Fed’s new policy is just operation (2), disconnected from (1). Operation Twist is less effective than a potential QE3, therefore, to precisely the extent that operation (1) makes a difference.  [But] does it?

As Mr. Rognlie correctly points out, from a practical stand-point, extremely short maturity T-bills are as near-money an asset as one can get; any “punch” from QE2 was mainly to have come from the yield curve flattening at the long end (the operative idea here is Keynesian to the core, in its emphasis on business spending — by swapping long bonds for cash, Mr. Bernanke hopes banks will lend to businesses who’d be taking out loans to build factories and such, creating jobs).  Thus Operation Twist has the potential, at least, to be more of an impetus to credit creation than has been commonly understood.

In a further hint at future inflation in the quantity of circulating credit, the Fed Board announced a permanent position in mortgage markets: to help support Fannie and Freddie’s liquidity and market-making for mortgage debt, the Fed will, moving forward, now re-invest principal payments from its holdings of agency debt and agency mortgage-backed securities back into GSE mortgage-backed securities.  In other words, what was billed three years ago as a temporary extraordinary measure is now being made a permanent part of Fed funding operations.  The remarkable thing about this was how unremarkable it was to the press and investors, who evidently have come to love the flood of Fed liquidity as much as a main-lining addict.

The Fed staff next reviewed the potential implications of reducing the interest rate that the Federal Reserve pays on reserve balances that depository institutions hold in accounts at the regional Fed banks.  This is worrisome if and when investor “animal spirits” pick up: there are currently $1.6 trillion in excess reserves in the commercial banking system  held at the Fed.  This is, as it were, “dry powder”, available for lending as and when demand for funds picks up.  (The Fed is currently, in effect, paying at least $4 billion in annual interest into the commercial banking system to aid in its recapitalization — this represents about 5% of the Fed’s net profits last year, and thus represents a transfer of wealth from the American taxpayer to the shareholder owners of the nation’s banks.)

If the Fed cuts those interest payments to zero, they would become a wasting asset (earning zero return), and there would be renewed effort to extend loans to spur activity in the economy.  But the threat of inflation and dubious investment would then once again be a possibility, and potentially in large amounts: $1.6 trillion in newly lent reserves has the potential to become more than $11 trillion in new money creation,  thanks to fractional-reserve banking and the pyramiding of credit.  This compares to a current total M2 money supply (currency + checking + time deposits) of $9.7 trillion in the U.S., so there is, in theory, a reason to worry about a stagnating inflation in coming years.

What Does the Economy Look Like Now?  

The minutes of the September 20-21 meeting try to put a “positive spin” on the current data wherever possible:

Industrial production …. and output …. expanded, consumer price inflation appeared to have moderated since earlier in the year, and measures of long-run inflation expectations remained stable.  Additionally, real business spending on equipment and software appeared to expand further, and commercial and industrial loans were up year-on-year and improved from earlier in 2011. ….. Exports remain a bright spot for the U.S. economy.

Unfortunately, the unusal amount of negative data in these minutes (again, given the usual institutional bias toward at least a quasi-optimism) tended to crowd out the positive:

But real disposable income edged lower, and consumer sentiment deteriorated significantly further in August and stayed downbeat in early September, before the meeting.  Activity in the housing market continued to be depressed by weak demand, uncertainty about future home prices, tight credit conditions for mortgages and construction loans, and a substantial inventory of foreclosed and distressed properties. Starts and permits for new single-family homes in July and August stayed near the very low levels seen since the middle of last year. Sales of new and existing homes remained subdued in recent months, and home prices edged down further. ….[and], survey measures of business conditions and sentiment remained at muted levels in August and September.  Real business expenditures for office and commercial buildings moved up in recent months, but outlays were still at a very low level and continued to be restrained by high vacancy rates and tight credit conditions for construction loans.

Foreign economic growth declined in the second quarter. Growth slowed notably in Europe; economic activity also decelerated in the emerging market economies. Real GDP contracted in Canada due to a large decline in exports. Output also fell in Japan, reflecting the dislocations caused by the March earthquake. …..recent indicators suggested only sluggish gains in underlying economic activity. With the intensification of fiscal and financial stress in the euro area, measures of consumer and business confidence declined in August, and indicators of manufacturing activity [in Europe] deteriorated. For many emerging market economies, the recent slowing in growth of economic activity was most evident in exports, industrial production, and other indicators of manufacturing activity. ….More recently, however, increases in domestic food prices appeared to be pushing up consumer price inflation in some economies.

Since early August, the equity prices of large U.S. financial institutions fell and their credit default swap (CDS) spreads widened. More-pronounced declines in equity prices and larger increases in CDS spreads occurred for some European financial institutions. …… Gross public equity issuance by non-financial firms weakened substantially in recent weeks, and a large number of planned initial public offerings were shelved amid the heightened market volatility.

What Does the Fed think the Future Will Hold?

Given the above retrospective, the key question is, what does the Fed think will happen going forward?  This was what was unsettling:

In the economic forecast prepared for the September FOMC meeting, the staff lowered its projection for the increase in real GDP in the second half of 2011 and in the medium term. …..[L]abor market conditions and indicators of near-term economic activity, such as consumer and business sentiment, were weaker than anticipated. In addition, financial conditions deteriorated since the time of the previous forecast as investors pulled back from riskier assets. ……The increase in real GDP was expected to be sufficient to reduce the unemployment rate only slowly over the projection period, and the jobless rate was anticipated to remain elevated at the end of 2013.

Business sentiment has worsened, seemingly in response to weaker economic prospects and increased downside risks to the outlook for U.S. and global growth. Contacts at communications, technology, and transportation firms indicated that growth had slowed in those sectors; surveys also indicated that growth in the manufacturing sector had weakened during the summer.

….Overall labor market conditions had shown no improvement or had deteriorated in recent months and the unemployment rate remained elevated….exceptionally high level of long-duration unemployment could lead to permanent negative effects on the skills and employment prospects of those affected, and so reduce the economy’s longer-run productive potential.

[For U.S. banking:] …. [L]oan demand was weak. ….[S]ome large U.S. banks had seen further pressure on their stock prices and CDS spreads. Participants agreed that, if European policymakers did not respond effectively, European sovereign debt and banking problems could intensify, with potentially serious spillovers to the U.S. economy.

…..Many participants saw significant downside risks to economic growth…. with growth slow, the recovery was more vulnerable to adverse shocks. Risks included the possibility of more pronounced or more protracted deleveraging by households, the chance of a larger-than-expected near-term fiscal tightening, and potential spillovers to the United States if the financial situation in Europe were to worsen appreciably.

Summary of the Fed’s Views on the Near Future

We think it all adds up to the following:

(1)  Mr. Bernanke is at heart an inflationist; along with several sympathetic members of the Board of Governors, the Chairman is not only unafraid, but determined to inject large amounts of money-creating reserves into the U.S. commercial banking system in order to lessen the impact of the deflation in credit that accompanies deleveraging (in sympathy with Mr. Bernanke, the Chicago Fed President, Charles Evans, gave a remarkable speech last month telegraphing the likelihood of much larger amounts of quantitative easing in the months ahead).  It seems to us that the Fed sees long-run inflation expectations and considerable slack in labor and product markets persisting into the indefinite future, and hence they project that inflation will be subdued in 2012 and 2013.  This gives the Fed license to embark on further quantitative easing in the period ahead.

This implies a strong likelihood of continued persistent devaluation of the U.S. dollar in the next few years at least, absent any major policy changes out of Washington.  This does not negate the possibility of short run favor for the dollar in the case of even deeper problems elsewhere, as per the current volatile situation in the Eurozone: the dollar is, for now, still the world’s safe-haven currency.  But several countries have now repaired their public fiscs to a far greater degree than the United States, and as the prospects for regional growth are greater elsewhere in the years ahead, capital will flow elsewhere.

(2) The implications of this follow axiomatically to the degree this is true.  Industrial commodity demand in the next several years is likely to maintain steady growth for Asia and emerging economies, albeit admittedly with fits and starts (e.g., China’s potential bubble at the moment).  Hard assets with a flow demand for industrial use thus become relatively more valuable in dollar terms, and gold, which has an historic monetary function as well as being in high demand by central banks and governments, should continue to be favored.

(3)  This in turn is a cause for concern for U.S. equities and housing, for two reasons.  First, a study of the post-Civil War economic history of the U.S. reveals an interesting statistic: the ratio of the U.S equity and housing indexes to the price of gold is an excellent real-time predictor of the health of the U.S. economy.  When that ratio is rising, the U.S. is benefiting from steady and sustainable growth.  When that ratio is declining or stagnant, slow growth or recession are manifest.

Secondly, the Fed has signaled high unemployment will be with us indefinitely.  There has never been an example of an economy with persistently high unemployment and sustainability of solid GDP growth.  Slow growth and/or recession must per force be the result in this case.

To say this differently, and as the late Warren Brookes used to put it, when the economic climate is positive, investors are willing to bet on the future, as evinced in risky corporate equities: this is a bet on the never-ceasing genius of the human mind, to innovate and create wealth and progress.  Conversely, when the better investment play is in gold and hard assets, the betting is, in essence, on the past — on assets that already exist and are static in their potential.

Unless fiscal policy changes in the United States, the Federal Reserve’s note this week was a bleak statement about our medium term prospects.

(4) Alarmingly, a strange admission of Fed confusion was contained deep within the 8,000 word proclamation:

Participants saw considerable uncertainty surrounding the outlook for a gradual pickup in economic growth. It was again noted that the cyclical impetus to economic expansion appeared to be weaker than in past recoveries, but that the reasons for the weakness were unclear, contributing to greater uncertainty about the economic outlook.

We beg to differ.  The reasons for economic weakness are remarkably clear: can the elephant not see itself in the mirror?  The U.S. economy has just suffered a $12 trillion loss of capital wealth thanks to massive malinvestment, spawned by ersatz (and at times corrupt, as per Franklin Raines at Fannie Mae) government intervention in the housing markets, and meddlesome encroachment into other areas of the private sector that have in essence led to a partial decapitalization of the U.S. economy.  Sadly these fiscal and regulatory errors were fueled and ratified by years of Federal Reserve pliancy in monetary policy, that is to say, in a word, a weak dollar.  The continuing torpor now felt in so much of the global economy has its origin in the United States, whose business sector now exists in literal fear of U.S. government policies — and that includes their discounting the purposive dollar devaluation led by the Fed, and aided by the Treasury.

That the current Federal Reserve cannot account for continuing economic weakness is a sad testament to where we stand now.  Rather than push for a strong dollar that would incite job-creating capital investment in the United States, the Bernanke Fed is determined to expand its balance sheet indefinitely, and engage (and lead) a global competitive devaluation among currencies.  Rather than encourage the U.S. political system to return to fiscal prudence and a pro-growth policy mix that would entail lower levels of federal spending, the Bernanke Fed is spooked by the prospect of near term fiscal consolidation.  As the British Army sang at Yorktown, the world is indeed turned upside down.

Our increasingly confident feeling is that, absent a change in policy regime in Washington that might well require an electorally-induced break, the U.S. is in for a generation of 1970s-style stagnation, in the context of 1930s-style deleveraging.   That is to say, not unlike Japan for the past 20 years, only with more consumer price inflation eventually.  On that note, the chart below shows the recent strong pick-up in bank deposits, impelled by successive rounds of quantitative easing:

Chart I.  Demand Deposits in the Commercial Banking System in the U.S.

This holds the promise for an eventual rise in the price level in the U.S., though we do agree with Fed assessments that it will be mild thanks to the ongoing debt deflation. Still, if CPI rises return to the 5-7% range in the years ahead, while not at 1970s-levels, that is enough to stunt growth considerably, at a time when strong growth is urgently needed to lower U.S. debt levels.

What this all adds up to is that the Fed’s pronouncement was perhaps remarkably candid in a new era of welcome sobriety after a century of increasing government hubris.  What we cannot agree with is the implicit thesis inside the Fed that our fate is sealed — that the “New Normal” of a sclerotic economy is unavoidable, and it is Washington’s job now to manage our relative decline as best as able.  In a free society, the future is a choice, because policy is a choice.  Deep tax cuts on profits and income combined with government spending restraint, repeal of burdensome regulations that ultimately will destroy millions of jobs, and a commitment to a strong dollar and free trade will guarantee prosperity: the future looked bleak in Germany and Japan in the summer of 1945, too, but both of these countries more or less followed this policy prescription.  The United States has many bright tomorrows in store, if it will merely return to the laissez-faire policies of yesterday that have never failed.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@alhambrapartners.com. 

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